Modern Finance literature persistently ignores the systemically destabilizing effects of financial bubbles. As a result, periodic speculative excesses, which hugely deviate from the rational models of mainstream finance, are largely unexplored, especially with regard to institutional investors’ behaviour in financially euphoric environments. My main objectives are to expose the premises, which the speculative bubble was built on, and the factors affecting institutional investors’ investment decisions, objectives and risk attitude in speculative bubbles. Using a series of semi-structured interviews with fund managers that worked during the Cyprus bubble of 1999, this thesis aims to contribute to the limited literature regarding institutional investors’ speculation. I draw from Abolafia and Kilduff, Kindleberger, Minsky, and Galbraith in order to provide a descriptive framework of speculative bubbles, in which institutional investors appear to be purposive, contrary to and at the expense of retail investors and the systemic stability.
The empirical data suggest that the roots of speculative bubbles are set by an event with perceived real economic consequences, which is seen to improve economic conditions and shift investors’ expectations. Afterwards, the rising share prices keep inviting an increasing number of speculators who create a new reality by replacing reason with what appears to be misinterpretation and misunderstanding. In this environment, regulatory failure, rumours and ‘strange friendships’ appear on the scene. Additionally, there is strong evidence suggesting that the institutional investors’ understanding of risk in speculative markets, contrary to the conventional wisdom, is particularly problematic; a phenomenon I call ‘risk paradox’.
The implications of speculative bubbles and institutional investors’ risk attitude are crucial in understanding the limitations of rational models that prevail in finance. This thesis argues for situating investment activity within its social, and frequently, speculative context. It contributes to understanding the behaviour of institutional investors in speculative markets and calls attention to their irrational investment behaviour.